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Needed: An About Face At The Top Three Central Banks

August 04, 1996

Economic Viewpoint

NEEDED: AN ABOUT-FACE AT THE TOP THREE CENTRAL BANKS

For the next few months, the performance of the world economy hangs on how monetary authorities in the top three economies handle the trade-off between growth and inflation. In Germany and Japan, the central banks must understand that the most immediate risk is renewed slowdown, not inflation. Central banks in Europe and Asia have for too long been obsessed with inflation. By contrast, in the U.S., with the unemployment rate at 5.3% and employment costs edging up, it's time for policy makers at the Federal Reserve Board to worry about overheating.

Barely a year ago, Japan was the weakest link in the world economy. It is just now emerging from a serious slump marked by price deflation. Last year's fiscal stimulus, the big drop in the value of the yen, and easy money all spurred recovery. Next, though, the government is planning a major consumption tax hike for early 1997. Moreover, aggressive restructuring by Japanese companies--investing offshore and bringing in imports--is under way. Unsurprisingly, business and consumer confidence remain fragile. Yet the Bank of Japan has begun to talk about the need to raise rates.

PRIME THE PUMP. The absence of inflation and rampant balance-sheet problems in Japan mean that monetary policy must stay easy. If the transition from fiscal stimulus to restraint does not get help from accommodating monetary policy, Japan's recovery will falter. Another slump or worse in Japan will hurt all of Asia--and thus deal a blow to a large chunk of the world economy.

Similar ripple effects could occur in Europe. There, the Bundesbank effectively runs monetary policy for all of Europe. In the aftermath of unification, the Buba did a great job in bringing inflation under control. That task is now accomplished--inflation is down to less than 2%--but the Buba keeps on waging the fight. The German economy is barely emerging from a recession. In fact, there is hardly a sign of recovery. Meanwhile, major fiscal tightening is scheduled across Europe as everybody undergoes the ritual cleansing required by the Maastricht treaty rules for monetary union.

Playing a hard-money strategy has served Germany well over the past few decades, and it is tempting to think it will forever be a good strategy. But that is not the case. Germany has become too expensive, industrial dynamism is gone, unemployment is high and rising, and the welfare state is an unaffordable luxury--just as many German exports are luxuries to overseas buyers. The labor market is inflexible, with the cost of manufacturing labor at $25 an hour against only $15 in the U.S. Budget restraint will produce more unemployment unless interest rates are cut by one or two percentage points and the Deutschemark depreciates substantially against the dollar.

RECESSION FEARS. For the Fed, the policy problem is entirely different: The U.S. economy is at full employment, and more important, the first signs of renewed inflation have appeared in the employment cost index. This is the time for gentle monetary tightening to lock in the benefits of more than a decade of disinflation. It's true that inflation hawks have called for tighter policies for some time, and it's fortunate that the Fed did not heed their advice, since it would have meant that millions of jobs would not have been created. But the latest growth spurt has brought with it a slight acceleration of inflation. Now it's time to bring the growth rate down to 2%.

Delay merely risks bringing back the old pattern of overexpansion followed by a sharp reversal with the risk of outright recession. Indeed, every recession in the postwar period was induced by the Fed. With prudent monetary policy--a correction toward slower growth just now--we can put aside the fears of recession and expect to cruise along indefinitely. The stock market correction, higher long-term rates, and an anticipated slowing in growth might do the trick. But the greater risk is that output isn't slowing enough to curb inflationary pressures, and that three months from now the Fed will have to scramble to tighten policy. Right now is a good time for the Fed to signal that it will not tolerate inflation higher than 3%--even if the stock market is weakening.

In Europe, central banks take inflation too seriously and understate the scope for monetary policy to help restore prosperity. They should take a lesson from the highly successful U.S. strategy of the past decade. In Japan the central bank is plainly clueless; just looking at any undergraduate textbook will help. For the Fed, the challenge is biggest: Accept that we have reached full employment and turn preemptively conservative.BY RUDI DORNBUSCH